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Is the Fiscal Cliff a Double-Black Diamond?

In my younger years, I did not ski.  In my mid-forties, I finally learned to ski and loved it – before my knees began to whine.  When you ski, you begin on the easiest slopes; those marked with a green circle, progress to blue squared, intermediate slopes and then to those marked with a black diamond.  Only the very accomplished skiers, however, ski the double-black diamond trails.  I recall looking down these trails and thinking that they looked like a cliff, going straight down.   I marveled, however, at how exceptionally talented skiers could traverse the mountain on these trails and succeed in making it to the bottom.  The United States, I believe, is like the experienced skier, when dealing with fiscal challenges.

We face what the media is calling a “fiscal cliff”.  While the “cliff” is a formidable challenge with a FY 2012 federal budget deficit of $1.1 trillion (7.3% of gross domestic product (GDP)) and total public debt of 72.8% of GDP.  Projected growth in costs, under current benefits, in Medicare, Social Security, and Medicaid is projected by the Congressional Budget Office to create a federal budget deficit that grows from 7.3% to 12% of gross domestic product by 2022 – adding to total federal public debt*.  Does this mean we will soon be thrust off the fiscal cliff or will we learn to traverse the steep and dangerous trail in front of us?  I believe we will do the latter.  Why?

If last year’s Budget Control Act takes effect, federal discretionary spending will drop from 8.3% in 2012 to a post World War II low of 5.6% in 2022.  Regardless, total federal outlays will continue to grow, as a result of entitlements, and reach 21.3% of GDP in 2018-19.  If this is addressed with tax increases, the entitlement squeeze will be deferred but not eliminated.  Moreover, total federal revenue will approach 20% of GDP, compared to 15.5%, currently.  Budget deficits will shrink and federal debt will fall, until the growth in Medicare and Medicaid expenditures overtakes the tax increases.  Thus, we have not averted disaster.  We have simply passed it on to our children.  We turn our skis….

Alternatively, we defer all spending cuts, let discretionary spending grow with GDP, and watch total federal outlays approach 25% of GDP by 2022.  If this is coupled with no tax increases for those making less than $250,000 with upper-income and investment income tax rates rising, as is currently scheduled to occur in 2013, we would see federal revenues rise.  Under this scenario, total federal debt will continue to grow at a rate faster than the economy, although the annual budget deficit would decrease due to the growth in revenues.  As we’ve seen in our European cousins, the rising overall debt burden will cripple the economy, especially if interest rates begin to increase with a strengthening economy.  Thus, we must turn our skis….

The way before us is steep, if we accept the inference that our federal budget is on a dangerous path.  There are wide differences of opinion with respect to answers.  The population voted with President Obama to increase taxes on the high income but revenues need to increase to over 20% of GDP in the early 2020s to avert disaster.  The population will likely not accept this scenario, if they think others are benefiting at their expense.  Thus, compromise must follow.

Taxes will be increased and the growth in entitlement spending will be slowed.  Benefits for expenditures such as Medicare, Medicaid, and Social Security, will be slowed.  This will be done, regardless of the effect on the electability of our representatives.  Eventually, leadership will arise in our “leaders” and hard decisions made.  Areas of discretionary expenditures, such as the military, education, basic research, agriculture, among others will be forced to experience slower levels of growth, while some entitlement spending is reduced or, perhaps eliminated – such as increasing the age for Medicare and Social Security eligibility.  This approach – to combine the “left” leg (tax increases) with a parallel move by the “right” leg (spending decreases) will allow our nation to safely negotiate this slippery slope.  We will safely descend the mountain and avert financial and political disaster.

We have no choice.

* Much of these data came from Alan Levenson, Chief Economist at T. Rowe Price. It is contained in the T. Rowe Price Report Number 117, from fall 2012.